Even wealthy European nations in trouble

Europe's problems are well documented. Many European nations have high, and in some cases, unsustainable levels of debt, compounded by a cluster of maturities and ratings pressures. Public finances are weak. European banks have either significant exposure to the weak property sector or sovereign debt. Sluggish even before the crisis, Europe's growth rates are too low to sustain current debt levels. Many European countries have uncompetitive cost structures in global terms. A number of nations have lost access to commercial sources of finance.

The crisis has highlighted the inflexibility of a single interest rate and common currency, which limits policy options.

The scale of the problems, the inadequacy of financial resources available and political difficulties mean decisive actions to resolve the European debt crisis are unlikely. Eurozone members remain committed to avoiding the unknown risks of a default and departure of countries from the euro. This means assistance will be forthcoming, although the exact form and attached conditions remain uncertain.

Peripheral countries will be forced to rely on the European Stability Mechanism (ESM) and the European Central Bank (ECB) to provide funding. Central banks in stronger countries will continue to use the TARGET2 (Trans-European Automated Real-time Gross Settlement Express Transfer System), a payment system to settle cross-border funds flows within the eurozone, to finance peripheral countries without access to money markets to fund trade deficits and capital flight.

Over time, financing will become concentrated in official eurozone agencies, the ECB and the TARGET2 system. Risk will shift from the peripheral countries to the core of the eurozone, especially Germany and France.

German guarantees supporting the European Financial Stability Facility are Ç¨ 211 billion. The ESM will require a capital contribution from Germany. If the ESM lends its full commitment of Ç¨ 500 billion and the recipients default, Germany's liability could be as high as Ç¨ 280 billion. There is also the indirect exposure via the ECB and the TARGET2 claims.

The size of these exposures is large, both in relation to Germany's GDP of around Ç¨ 2.5 trillion, and German private household assets, which are estimated at Ç¨ 4.7 trillion. Germany also has substantial levels of its own debt (around 81 per cent of GDP). The increase in commitments, or debt levels, will absorb German savings, crippling the economy.

Over time, this process will mean de facto debt mutualization and financial transfers by stealth. This will have substantial costs. For the peripheral nations, financing assistance will be available, albeit in doses which will keep the recipient barely alive and prolong its suffering. It will require adherence to strict austerity policies, which may mire the economies in recession.

Living standards will be reduced by internal devaluation. Employment conditions, pension benefits and social benefits provided by the state will become less generous. Taxes will rise, reducing after tax income.

In the stronger nations, savers will see the value of their savings fall. They too will suffer losses of social amenities as income and savings are directed to support weaker eurozone members.

Europe will find itself locked in a period of subdued economic activity and high unemployment.

Outflows of actual cash to beleaguered nations, significant rating downgrades for core eurozone members or a rise in inflation and consumer prices may alter the dynamic quickly. If voters in Germany and other stronger states become aware of the reality of debt pooling and institutionalized structural wealth transfers, then the outcome might be different. Continued deterioration in economic activity requiring further bailouts as well as unsustainable unemployment and social breakdown may still trigger repudiation of debts, defaults or a breakdown of the euro and the eurozone.

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